Dear Keynesians: The Supply Side Eventually Matters

For most of the life of this blog, I’ve been screaming into the abyss that the demand side can sometimes matter in macroeconomics, and free market people were being insane for ignoring it.

Unemployment is at 7.9%, and that would seem to imply that more than one in three people who are unemployed are unemployed because of a shortfall in aggregate demand. Others paint the picture as being even worse by citing alternative measures of unemployment. I don’t think this is a good way of characterizing the situation, and the people who paint the picture this way do so as a way to bash Obama. It was these people in mind when I tweeted a few days ago,

People who are quoting the broader measures of unemployment… stop. Economists defined unemployment the way they did for good reasons

I think this is entirely incorrect, because I believe that even using the unemployment rate as I did above as a basis for measuring aggregate demand shortfall is myopic.

I’m a cynical bastard, because in my experience being a cynical bastard will on average get you closer to the truth. So even before the Great Recession, I don’t think the natural rate of unemployment was 5%. I think it was 6%. When the Fed pushes it below 6%, I interpret that as overheating the economy.

That means that no more than nine people in a thousand are unemployed as a result of an aggregate demand shortfall. In other words, “aggregate demand shortfall” should be no higher of a priority today than it would have been in the minds of Keynesians (not me because I’m a cynical bastard) when it was 5.9%.

But wait – we are making aggregate demand the god of the gap. I don’t think that regime uncertainty, all those other little extensions to the social safety net, or being afraid to start a business because the president is black amount to much of the unemployment. But they (or at least the first two) amount to something. Half of a percentage point sounds right, but one percentage point is by no means out of the question. Again, in other words, I believe it is completely plausible that we are at full employment.

If we were to separate economists who believe in the concept of aggregate demand shortfall, we’d get something like this.

1. Those who believe in it, but don’t understand why you need more than monetary policy to address it (i.e. people like me).

2. People who don’t believe monetary policy will always fix it, but want to use fiscal policy in very specific ways, like using automatic stabilizers, writing checks and sending them to people, or sending checks to states. Maybe infrastructure projects too, if you can find those chimerical shovel-ready projects.

3. People who will burn everything in a fire if they think it will increase aggregate demand. Screwing with free trade, increasing unemployment insurance to “increase spending,” arguing for minimum wage increases during a recession.

Three is nuts. I can understand two even if I can’t understand it (that makes sense, trust me). It was irresponsible to push for those things when unemployment was 10%. But talk of doing more of three when an aggregate demand shortfall is of tertiary concern is crazy.

Eventually, the supply side matters. Once upon a time, the fastest way of improving labor markets was fixing the demand side. Now, the fastest way to improve it is to cut unemployment insurance back to levels to where they were.